Many people continue to ask me their opinions on ETFs and how to select it. Years ago this was easy but in recent times and it has become a little bit complex. Here are some tips on what to look out for when selecting an ETF for investment purpose:
1. Select reputable fund managers. This is because you want to select the ETF fund managers to have the highest chance of having a viable business so that you will not face a situation which you are forced to sell your ETF just because your ETF fund manager exit the business. This has happened many times already.
2. Select an ETF which has large fund size. Similar to the first point, you want to ensure that the ETF is profitable to the fund manager. Since an ETF’s management fee is very low, their margins are tight. You may want to consider ETF fund size that is in the region of at least US$1 billion. A management fee of 0.5% per annum translates to revenue of just US$5 million. This amount isn’t a lot of a multi-national company. So you can see the US$1 billion fund size is already quite small.
3. Ensure that the ETF holds the desired asset class directly. For example, if you are looking at an ETF to hold stocks, make sure it is actually holding stocks. Similarly, if you are looking for an ETF to track a bond index, make sure it is holding bonds. In recent years, many ETF providers have come up with ETFs that do not hold the asset class directly but instead they go through an intermediary stage via swap or equity linked notes (ELN). These derivatives have counterparty risks that are not present for those ETF that holds the asset class directly. In other words, avoid derivative based ETFs such as swap-based and equity-linked notes.
4. Ensure that the ETF has liquidity. You can check the liquidity of the ETF from the stock exchange in which it is listed. If liquidity is poor, you could end up buying or selling at a poor price.
5. If there is no liquidity, make sure there is a committed market maker available. These market makers are contracted by either stock exchanges or ETF fund managers to buy and sell from investors. But not all market maker are the same because their commitment level varies. Ensure they are committed to provide liquidity of certain volume. Unfortunately, I have yet to come across any market maker which has publicly published their volume commitment.
6. ETFs are listed in many stock exchanges in the world. Make sure that the jurisdiction which you invest is tax friendly. There are two tax considerations. One, make sure that the foreign jurisdiction do not impose tax on distributions (like dividends). For US listed ETFs, the US government will impose 30% tax on any dividends paid to you (assuming you are a Singapore tax domicile investor). You can see it is painful to have 30% of your money taken away like this. Two, make sure that the foreign jurisdiction do not impose estate duty. Singapore has removed estate duty but some countries still impose it. You wouldn’t want to leave behind a large tax liability to your love ones when you leave to the next world.
7. Low tracking error. Make sure that the ETF you buy has low tracking error compared with the index it is supposed to follow. The difference between the performance of the ETF and the index should just be the expense ratio. If there is a large tracking error, it means the ETF fund manager is not doing its job.
8. You should only open a brokerage account with a broker regulated by Monetary Authority of Singapore (MAS). While many ETFs are listed in many parts of the world, you are going to hand your money to the brokerage company which usually is the custodian that holds your ETFs listed outside Singapore. If you have a dispute with the custodian, at least you have some recourse from MAS. Moreover, you can complain to your MP, write to Straits Times forum and even protest at Hong Lim! Of course you can always seek legal action. All these are only possible if the broker is located and regulated by Singapore. Never open an online brokerage account and hand your money to a foreign broker outside Singapore. If a dispute arises, you cannot complain to your MP, write to ST forum and of course MAS will not help. Your only recourse is to take legal action. Can you imagine the legal cost of engaging a foreign lawyer to take legal action against the foreign broker? Also, imagine how much traveling cost you will incur to travel overseas!
9. Finally, always consult a financial adviser if you are not sure. However, as ETFs do not pay commission, most advisers will not be willing to advice you.
This article first appeared on CPF Board's IM$avvy website: www.cpf.gov.sg
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